Amending Partnership/ LLC Agreements in Response to New IRS Partnership Audit Rules

Transcription

1 Amending Partnership/ LLC Agreements in Response to New IRS Partnership Audit Rules Effective for tax years beginning in 2018, radically new rules will apply to IRS audits of partnerships and LLC s (that are taxed as partnerships). The rules are extensive, but at the risk of oversimplifying, the new tax audit rules have brought about major changes in two areas: 1) Who may participate in IRS partnership audits and appeals? and 2) Who pays a partnership tax audit deficiency? For tax years prior to 2018, the answer to the first question was, with limited exceptions, the partners/members of the partnership/llc, together with the Tax Matters Partner, who had primary authority to seek judicial review on behalf of the partnership/llc. For 2018 and after, the answer to 1) is the Designated Partnership Representative, exclusively, and to 2), the partnership or LLC itself, unless elections are made for the partners/members to pay the tax liability themselves. More specifically: First, unless certain elections are made, any tax adjustments resulting from an IRS audit will result in the tax deficiency being assessed against the partnership/llc (not the partners/members) for the year in which the audit is taking place (the Adjustment Year ), and not the prior tax year that is actually being audited (the Reviewed Year ). See 6221(a), 6225(a)(1), & Second, the tax (the Imputed Underpayment ) is calculated at the highest individual marginal tax rates then in effect, regardless of whether the tax rates of the partners or members would be lower. 6225(b)(1)(B). Third, the tax matters partner designation has been eliminated, to be replaced by the Partnership Representative, who has far broader powers to deal with the IRS than before. Unlike under pre-2018 law, individual partners and members have no rights to participate in or challenge an IRS audit, which means that the rights and responsibilities of the partners/members vis a vis the Partnership Representative should be carefully defined in the partnership/operating agreement. See Citations are to the Internal Revenue Code.

2 2 P a g e As discussed further below, there are many issues which can only be addressed by amending partnership/llc agreements. Elect Out? Before discussing the potential impacts of these changes in more detail, the possibility of a partnership (including LLC) electing out of the new audit rules must be considered Only certain partnerships (eligible entities) may elect out of the new audit rules. See 6221(b). a. 100 or fewer partners; and b. Each partner must be an i. Individual ii. Estate iii. C corporation (or equivalent foreign entity); or an iv. S Corporation c. A partnership will not qualify as an eligible entity if one or more of its partners is a: i. Trust (including revocable trusts) ii. Single-member LLC; or a iii. Partnership 2. Election out must be made annually on the partnership tax return. 3. Much of the literature concerning how to deal with the new rules is focused on ways that partnerships can re-structure ownership so that a partnership can qualify to elect out. This approach, in my view, will in many cases be inappropriate considering the significant potential issues that can arise if an election out is made, and IRS therefore audits individual partners, not the partnership. In fact, contrary to what one might expect, planning for an election out will almost certainly be more challenging in many cases than planning to accommodate the new rules. 4. Here are some of the most important considerations for partnerships contemplating electing out of the new audit rules: 2 Hereinafter, the terms partnership and LLC will be used interchangeably, since LLC s are typically treated as partnerships for tax purposes.

3 3 P a g e a. In the absence of an enforceable agreement for reimbursement, the partners who are under audit will bear all the costs of responding to/dealing with IRS. i. In practice, the IRS will probably focus the audit on the general partner/manager, which is what they did before TEFRA rules in 1982, but in the case of manager managed LLC s the IRS selection of the member to be audited might be arbitrary. ii. The partnership agreement could make it clear that the partnership bears the costs of audit, but there is a risk that the payment of costs by the partnership may be treated as constructive distributions to the partners who are being audited, thus unbalancing partners capital accounts. b. The partnership/llc agreement should prohibit transfers of interests to nonqualifying partners/members and classify any purported transfers as null and void. c. Unless the partnership/operating agreement states otherwise, there is no requirement that the partners under audit cooperate with each other regarding i. Supplying information in response to audit requests ii. Coordinating positions/arguments on issues raised d. A failure to properly coordinate an audit defense for an electing out partnership could result in significant costs to the partnership and the partners. i. Partnership agreements for electing out partnerships should spell out the cooperation required by partners, including sharing of all communications with the IRS and production of any information relevant to the audit, as well as provisions preventing a partner from taking actions that could jeopardize the positions of other partners or delay resolution of the audit (e.g., settling a case based upon a position that is inconsistent with that taken by other partners or extending the statute of limitations). These provisions should be enforceable by specific performance and injunctive relief, since other remedies would likely be inadequate in an audit situation. ii. During my employment at the IRS pre-tefra 1982, I recall the examination division pursuing audits of limited partnerships by examining returns of the general partner to conclusion and then imposing the same results on the limited partners, without giving them a chance to raise newer or better arguments. In my opinion, this divide and conquer approach may return.

4 4 P a g e iii. I recall cases where a general partner would keep limited partners in the dark about an audit until the case was settled or lost in court, then skip town or file for bankruptcy. The incentives for general partners to do this were high since they often had small percentage interests and limited exposure to tax liability. In theory, the limited partners could challenge their separate tax assessments, but in practice they often lacked the resources or access to partnership records that would allow them to do so effectively. e. Individual audit results could differ, particularly for partners living in different parts of the country, resulting in inconsistent treatment of capital accounts, which could create confusion about partner s rights to a share of partnership assets upon liquidation or withdrawal, among other problems. i. These problems are particularly acute for partnerships that have 704(c) or (b) allocations, which reference the partners capital accounts. ii. Serious inconsistencies could result from audits of partners subject to potential mixing bowl or disguised sale transactions under 737 and 707. None of these rules existed before TEFRA. iii. Partnership agreements should clarify what happens upon liquidation if capital accounts are inconsistent as the result of an IRS audit that treats partners differently. It may be difficult to draft these provisions in a way that would satisfy the substantial economic effect safe harbors in the 704(b) regulations. 5. Before electing out, a partnership should evaluate its business activity to determine the inherent tax risk, then make plans to address them in advance of an audit (preferably set forth in a written partnership (or LLC) agreement. Tax return preparers should confirm that the partners understand the implications of electing out of the new audit regime before checking the box on the tax return. 6. Although it may be possible to qualify a partnership or LLC for the election out by transferring disqualified partnership/member interests to an S Corporation, there would likely be adverse tax ramifications in most cases--not to mention added complexity--and the benefits of electing out of the new rules are dubious, since as discussed below, under the new rules the partnership can avoid having to pay the Imputed Underpayment by electing to pass out the audit adjustments to the partners who would then become responsible for paying the resulting tax.

5 5 P a g e Issues Raised by the New Partnership Audit Rules 1. The default rules requiring the partnership entity to bear the tax costs of any audit adjustments will put the partnerships that are required by their loan or other agreements to maintain minimum amounts of cash reserves at risk of being in default on those agreements. a. With certain limited exceptions, unless a timely election is made to push out audit adjustments to the partners during the reviewed year, or the partners voluntarily agree to amend their tax returns for the reviewed year to pay their share of taxes on such adjustments, the tax attributable to the audit adjustments is calculated at the highest individual marginal tax rate and is imposed on the partnership itself, not on the partners. b. Partnerships/LLCs that are required to maintain specified amounts of cash reserves pursuant to their loan or other agreements will have to maintain amounts in excess of required reserves at the time of an audit adjustment to avoid default, unless the partners agree to contribute the necessary amounts to the partnership as capital contributions. c. To avoid default in these situations, partnership/llc agreements should expressly authorize the partnership representative to make the necessary elections to push out the tax liability to the partner/members, with appropriate indemnification and exoneration provisions for the representative so acting. Since the window for making the election is narrow (within 45 days of receiving notice of final partnership adjustments), careful attention will have to be paid, in advance, to the procedure for doing this. The rules and procedures governing the election are discussed in more detail below. 2. Another potential problem arises if the partners have changed between the reviewed year and the year of the audit. If the partnership pays the tax, the economic burden will fall on the current partners, not the reviewed year partners. a. Advisers to purchasers of partnership interests would be well advised to carefully review the provisions of partnership/llc agreements to determine what provisions to include in a purchase agreement and/or amendment to the partnership agreement may be appropriate in these situations. 3. For partnerships which are not required to maintain minimum cash reserves, an analysis should be made of whether the partnership or the partners should pay the additional tax resulting from an audit.

6 6 P a g e a. While it is possible to punt on this question by amending the partnership agreement to allow the partnership representative to make the decision based upon circumstances at the time, some partners may object to giving the representative that much power, and the representative could find themselves exposed to claims if the partners cannot agree on how to proceed. Perhaps more importantly, if the partners have changed since the year under audit, the current partners who control the partnership representative might take actions to their advantage over reviewed year partners, particularly with regard to timing adjustments like depreciation. b. If the partners cannot agree in advance on the answer to this question, an enforceable procedure should be put in place for making the decision, or perhaps a default approach which can be changed by a vote of the partners. c. As noted above, payment of the liability by the partnership causes the economic burden of the audit adjustment to fall on the current partners, regardless of who the partners were for the tax year being audited. 4. What are the alternatives to having the partnership pay the tax liability? a. The partnership representative can elect to push out the adjustment to the persons who were partners during the reviewed year (the year being audited). 6226(a). i. Election must be filed with the IRS within 45 days of the date of the notice of final partnership adjustment ( NOFPA ). 6226(a)(1). 1. This is half the time that the partnership representative has to file a Tax Court Petition in response to the NOFPA (90 days). 2. It is significant that the election (and the statement to partners discussed below) must be made before a Tax Court Petition is filed and before the final determination of the liability is made. ii. The partnership must furnish a statement to the IRS and to the partners showing each partner s name, identification number, and share of the adjustments as finally determined in the notice of final partnership adjustment. The time and manner of furnishing the statement will be the subject of regulations. 6226(a)(2). iii. Effect of push out election. 1. Partners during the reviewed year owe the tax on their respective shares of the partnership audit adjustments, calculated based upon

7 7 P a g e their previously reported taxable income for the reviewed year. 6226(b)(2)(A). This could result in a lower aggregate tax liability because of the ability to use the partner s lower marginal tax rates, if any. 2. Partners will apparently be liable for the % tax attributable to adjustments to their shares of partnership net investment income. The imputed tax liability that would otherwise be imposed upon the partnership if the push out election was not made does not include the 3.8% tax at present (a technical correction in this regard seems likely). 3. Interest and penalties are calculated from the due date of the partner s tax return for the reviewed year, at a rate that is 2 percentage points higher than normal. 6226(c)(2)(C). a. This is not true for deficiencies that are not pushed out to partners, or if the partners voluntarily file amended tax returns, so the push out election comes at an additional cost that will at least partially offset any benefits from using the partners lower marginal tax rates. 4. The tax is imposed in the year in which the audit adjustment statement is issued to the partner. 6226(b)(1). a. Technically if the tax is imposed in the year of the audit/statement, payment is not due from the partners until April 15 of the following year. i. The IRS would have 10 years from April 15 to collect the tax, which is different than the current rule which would start the collection clock running at the time of the deficiency assessment. ii. This rule means the IRS doesn t have to issue notices of deficiency to the partners for the reviewed years, thus preventing partners from being able to petition the Tax Court (supposedly only the Partnership Representative can do that but see next paragraph below). b. Presumably the partners are required to self-report the additional tax when they file their tax returns, although the IRS will obviously have matching information to make sure

8 8 P a g e they do. If a partner fails to self-report, query whether the IRS is required to issue a statutory notice of deficiency, or whether the tax adjustment is assessable like a math error? If the former, then a partner could theoretically obtain separate judicial review of the partnership assessments even if the partnership representative agrees to them. c. It is unclear how these rules would apply to tiered partnerships. i. The legislative history suggests that the upper tier partnership is taxed on the adjustments as if it were an individual, per 703. IRS Proposed Regs ii. However, 703 refers to the determination of a partnership s taxable income; the calculation of the tax is not covered since partnerships have not previously been required to pay taxes. iii. A technical correction has been proposed in Congress that would allow the partner partnership to elect to either pay the additional tax in the same manner as the audited partnership would pay the resulting imputed underpayment, or to pass the adjustment through all the tiers to the individual partners. b. Instead of a push out election, the partners can agree to file amended tax returns for the reviewed year, taking into account their respective shares of the audit adjustments. If returns are filed and any resulting tax due is paid, then the partnership s imputed tax liability is correspondingly reduced. 6225(c)(2). i. If the partners fail to pay the tax due, the partnership is back on the hook for the imputed underpayment. ii. If some partners file amended returns, but others do not, the partnership agreement should allocate the burden of the remaining imputed underpayment among the defaulting partners. 1. This would require a charge against capital accounts and against future partnership distributions.

9 9 P a g e 2. In some cases, the foregoing remedy will be insufficient to make the partnership whole, particularly if payment of the imputed tax liability by the partnership would cause it to be in default on its obligations to maintain cash reserves at a required level. 3. Indemnification provisions could be drafted but could only be enforced by legal action. 4. To avoid this scenario, it may be advisable to include operating agreement provisions requiring members to contribute their respective shares of the imputed tax liability to the LLC before the deadline for making the push out election, then distributing the funds back out to the members when the amended returns are filed. If some partners fail to contribute, the partnership representative would have the option of proceeding with the push out election to ensure that all partners share in the tax burden (any amounts previously contributed by partners could be returned to them). iii. Unlike the push out election, the amended return approach appears to have the advantage of allowing the partners to avoid the 2% additional hot interest on the deficiency, as well as allowing the use of potentially lower marginal rates of the partners. iv. As with the push out election, if the partnership has not contested the audit adjustments, it may be possible for individual partners to seek judicial review, in this case by paying the full amount of their individual tax liability and then filing a refund claim followed by suit in U.S. District Court or the Court of Claims. 5. Who will be the partnership representative and how will their duties vis a vis the partners be defined? a. Effective for tax years 2018 and after, partnerships and LLC s will be required to designate a partnership representative on the partnership tax return each year (according to proposed regulations). i. The partnership representative can be a legal entity such as a trust, partnership, or corporation, but that entity must in turn have a designated individual who serves on behalf of the entity partnership representative. Prop. Reg (b). Given the personal nature of the duties of the partnership representative, defining the legal relationship between the partnership and an entity partnership representative would be tricky. I suggest that the PR be an individual to avoid issues of imputed liability to other parties or owners of the entity.

10 10 P a g e ii. According to proposed regulations, a partnership will be able to name a different partnership representative on each year s tax return, if it chooses. iii. Once named, resignation, removal and replacement of the partnership representative will likely be subject to significant restrictions. Prop. Reg (d). 1. In general, the partnership representative cannot be changed until the IRS commences an audit (or the partnership amends its return via an administrative adjustment request relating to matters other than the designation of the partnership representative). b. The partnership representative has the sole authority to act on behalf of the partnership in an IRS examination, and all partners and the partnership are bound by the actions of the partnership representative i. This is a notable change from current law, where individual partners and groups of partners with 5% or greater interests can participate in the examination and contest the results, regardless of what the tax matters partner decides to do.

11 11 P a g e Sample Partnership/LLC Agreement Provisions 1) Selection of Partnership Representative. i The Partnership Representative of the Partnership shall be [NAME]. ii 2) Replacement of Partnership Representative. The Partnership Representative may be replaced by the Partners upon [PARTNERSHIP VOTE]. a. The replacement shall be effective with respect to all tax returns filed by the Partnership after such vote. b. A Partnership Representative who has been designated on previously filed partnership tax returns may be replaced, with respect to such tax returns, upon a [PARTNERSHIP VOTE] of Reviewed Year Partners as defined below, at such time and in such manner as permitted by applicable IRS rules and regulations. 3) Partnership Representative s and Partners Authority and Duties. iii a. The Partnership Representative, i. As provided by law, subject to the provisions below, shall have the sole authority to act on behalf of the partnership and its partners with respect to all matters governed by Subchapter C of Chapter 63 of the Internal Revenue Code, concerning the tax treatment of partnership items, including representation of the partnership in connection with the conduct and resolution of any IRS audit. ii. Is authorized, in their discretion, to retain experts, including experts on partnership tax issues, to assist the Partnership Representative in performing their duties. iii. Shall give notice iv, within 10 business days of receipt of any of the following documents issued with respect to any Partnership tax year (the Reviewed Year ), to the Partners who were partners during such Reviewed Year (the Reviewed Year Partners ), including the legal representative of a deceased Reviewed Year Partner s trust or estate): 1. Letter or other communication from the IRS concerning the commencement of an audit; 2. Notice of Proposed Partnership Adjustment;

12 12 P a g e 3. Notice of Administrative Appeals hearing; 4. Notice of Final Partnership Adjustment; v 5. Any pleading, notice, discovery request, motion, or other filing in connection with any court proceeding, including proceedings in the United States Tax Court. iv. Shall provide the Reviewed Year Partners prior notice of meetings with or appearances before the IRS or other governmental authorities, as well as court appearances and filing due dates. v. Shall provide regular reports to the Reviewed Year Partners on the status of the audit or court proceeding, and upon request by any Reviewed Year partner, the Partnership Representative shall furnish copies of any letter, notice, or other written communication from the IRS or other governmental authority regarding an audit or legal proceeding, and copies of any written response from the Partnership Representative to the IRS. vi. Shall make no decision regarding the matters listed below vi except pursuant to a majority vote [majority or supermajority] of the Reviewed Year Partners. vii 1. Extend the statute of limitations on assessment for any tax year; 2. Execute a waiver of restrictions on assessment, closing agreement, or any similar agreement resolving an audit; 3. Request a conference with the IRS appeals office; 4. Petition the United States Tax Court; 5. File a Request for Administrative Ad justment with the IRS, and appeal or seek judicial review of an IRS determination regarding the same. Notwithstanding anything to the contrary herein, in the event that, after notice is given to the Reviewed Year Partners pursuant to [REFERENCE NOTICE PROVISIONS] of a vote to be taken with respect to any of the actions listed above, such vote is not taken at the time specified in such notice, for any reason, the Partnership Representative may take or not take any of the foregoing actions that they determine, in their sole discretion, to be in the best interests of the Partnership.

13 13 P a g e b. The Partners shall fully cooperate with the Partnership Representative by providing any information or testimony requested in connection with an audit or any related legal proceeding. 4) Payment of Audit/ Litigation Expenses. a. The Partnership Representative shall pay, out of Partnership funds, all the necessary expenses associated with an audit of the Partnership and any related legal proceeding. viii b. If at any time the Partnership Representative determines that available Partnership funds are or may be insufficient to cover necessary audit/ litigation expenses, they shall notify the Reviewed Year Partners and call a meeting seeking approval for the contribution of additional capital to the Partnership, in accordance with the procedures ix set forth in Section of this Agreement. This paragraph shall be binding on all Reviewed Year Partners, whether or not they are currently partners of the Partnership. 5) Standard of Care and Indemnification of Partnership Representative. a. Standard of Care i. The Partnership Representative shall not be liable to the Partnership or to the Partners for any action taken in their capacity as such, except to the extent they engage in grossly negligent or reckless conduct, or a knowing violation of the law. x ii. The Partnership Representative is relieved of any liability imposed by law : 1. To the extent that they take (or do not take) any action in accordance with a Partnership Vote as provided in Section 3) a. iv. above. 2. For making a push out election pursuant to 6226(a) of the Internal Revenue Code, as authorized in Section below. iii. In discharging their duties, the Partnership Representative is entitled to rely upon information, opinions, reports, or statements, including financial statements and other financial data, if prepared or presented by: 1. One or more partners, officers, or employees of the Partnership whom the Partnership Representative reasonably believes to be reliable and competent in the matter presented;

14 b. Indemnification 6) Push Out Election. xi Vermont Tax Seminar P a g e 2. Legal counsel, public accountants, or other persons as to matters the Partnership Representative reasonably believes are within the person s professional or expert competence. i. The Partnership shall indemnify the Partnership Representative against any actual or threatened action, suit or proceeding whether civil, criminal, administrative or investigative, arising by reason of their capacity as such, except to the extent they engage in grossly negligent or reckless conduct, or a knowing violation of the law. ii. In addition, the Partnership shall advance or reimburse any expenses, including reasonable attorneys fees, incurred in investigating and defending any actual or threatened action, suit or p roceeding for which they may be entitled to indemnification under this Section. a. Except and unless the Partnership Representative is directed otherwise by the Partners pursuant to the provisions of Section below, the Partners authorize and direct the Partnership Representative to make the election under 6226(a) of the Internal Revenue Code (the Push Out Election ), in the time and manner provided by law and applicable regulations, with respect to any partnership tax year for which a notice of final partnership adjustment is issued by the IRS. b. The Partners acknowledge and agree that, pursuant to the Push Out Election: i. Any additional tax attributable to audit adjustments will not be imposed upon the Partnership, and the Partnership shall not be liable to the U.S. Treasury or to the Partners for such additional tax; ii. The Reviewed Year Partners will owe tax (or receive refunds) based upon their respective shares of the audit adjustments to the Reviewed Year; iii. The Partners who were Partners during tax years after the Reviewed Year (the Affected Year Partners and the Affected Years, respectively) will owe tax (or receive refunds) based upon their respective shares of any adjustments made to Reviewed Year tax attributes; xii iv. The Partners will owe interest on any tax liabilities for the Reviewed Year and for the Affected Years at a rate that is 2 percentage points higher than the deficiency rate otherwise provided by law.

15 15 P a g e c. The Partners authorize and direct the Partnership Representative to furnish to the IRS, and to each Reviewed Year Partner and Affected Year Partner, a statement of such Partners respective shares of any adjustment to a partnership-related item (Audit Adjustment Statement ), as provided by law and applicable rules and regulations. d. The Partners agree to report their respective shares of adjustments to partnership items and to pay, as part of their tax liability for the tax year in which they receive the Audit Adjustment Statement (the Adjustment Year ), their respective shares of any additional tax, penalties and interest, calculated based upon their taxable incomes for the Reviewed Year and for the Affected Years, as provided by law and applicable rules and regulations. e. The Partners acknowledge and agree that their liability for taxes, penalties, and interest pursuant to the Push Out election will be unaffected by their status as a Partner in the year during which such statement is issued. 7) Alternative Deficiency Payment Procedures in Lieu of Push Out Election. xiii a. Amended Returns by Partners xiv i. Upon a unanimous vote of the Partners, including the Reviewed Year Partners xv and the Affected Year Partners, then pursuant to 6225(c) of the Internal Revenue Code, the Reviewed Year Partners and the Affected Year Partners shall take partnership audit adjustments into account by filing amended tax returns for the Reviewed Year and for the Affected Years, in such manner and time provided for by applicable rules and regulations, or in lieu of filing amended returns, they shall pay any additional tax due and submit such information to the IRS as is required by law and applicable rules and regulations. ii. To effectuate the foregoing paragraph, the Partners may enter into a binding agreement providing for remedies to the Partnership and to the Partners in the event of a default xvi by a Partner or Partners in complying with the preceding paragraph. b. Payment by the Partnership xvii of the Imputed Underpayment Amount xviii i. Upon a unanimous vote of the Partners xix following the submission of a written certification by the General Partners/ Manager(s) that payment by the Partnership of the imputed underpayment amount pursuant to 6225(a) of the Internal Revenue Code will not cause the Partnership to be in default of any of its legal or contractual obligations, the Partnership shall pay such amount, including any interest and penalties, at such time and in such manner as provided by law and applicable rules and regulations.

16 16 P a g e 8) Adjustments to Partnership Items. The Partnership and the Partners agree to account for the Partners respective shares of adjustments to partnership items in a manner consistent with the Notice of Final Partnership Adjustment or such other document, agreement, judgment, or order constituting a final resolution of an audit. 9) Effect of Termination of Partnership. The Partners agree that, following the termination of the partnership for tax purposes pursuant to 708(b)(1)(A) of the Internal Revenue Code (no part of any business, financial operation, or venture of the Partnership continues to be carried on by any of the partners in the partnership): a. All the provisions of this Section shall remain in full force and effect as between and among the Partners, except to the extent that enforcement of any provision is contrary to applicable laws and regulations. b. Audit and litigation expenses after the termination of the Partnership shall be paid, upon notification by the Partnership Representative and following the approval of a majority of the Reviewed Year Partners, by such Partners, in accordance with their percentage interests in the Partnership xx. In the event a Partner fails or refuses for any reason to contribute or pay in cash xxi the amounts required pursuant to this paragraph within ten (10) days after notification by the Partnership Representative, the provisions of Section, relating to defaulting Partners for capital calls, shall apply as if the Agreement were fully in effect. THE FOREGOING TEMPLATE FORM PARTNERSHIP AGREEMENT LANGUAGE IS NOT INTENDED TO CONSTITUTE LEGAL ADVICE; PARTNERS AND PARTNERSHIPS SHOULD SEEK PROFESSIONAL LEGAL ADVICE BEFORE ADOPTING ANY OF IT. THE FOREGOING FORM IS AVAILABLE IN WORD FORMAT, WITH THE ENDNOTES INCORPORATED AS COMMENTS (FOR EASE OF REFERENCE). REQUESTS FOR AN ELECTRONIC COPY CAN BE MADE BY ING ME AT RMORGAN@MMGVTLAW.COM.

17 17 P a g e i Many partnerships are eligible to elect out of the new partnership audit rules. 6221(b). In general, this applies to partnerships with 100 or fewer partners, none of whom are trusts, single member LLC s, or partnerships. The election is made on a year by year basis. Although an election out is superficially appealing, there are significant risks to doing so, and partnership agreements will need detailed amendments to address them. See Terence Floyd Cuff, Finding the Path, 24 Los Angeles Lawyer, December Key issues involve restricting transfers of partnership interests to nonqualifying partners, providing for sharing of audit information and costs, and coordinating audit defense; drafting enforceability provisions will be challenging. ii If the Partnership Representative is an entity, consider provisions addressing the representative s authority to name a designated individual to act for the entity in the partnership representative role. iii The sample provisions here do not include any provision for compensation of the Partnership Representative. iv In lieu of paragraphs 3) a. iii.- vi. below, much broader authority over audit decisions can be given to the Partnership Representative as follows: iii. Shall provide regular reports to the Members who were Members (the Reviewed Year Members ) during any Company tax year under audit by the IRS (the Reviewed Year ), regarding the status of the audit or court proceeding, and upon request by any Member, the Company Representative shall furnish copies of any letter, notice, or other written communication from the IRS or other governmental authority regarding an audit or legal proceeding, and copies of any written response from the Company Representative to the IRS. v This notice starts a 45-day period to make the election to roll out the adjustments to the partners. Unless the partners agree to the roll-out in advance, the 10-business day notification period may be too short. vi The list below may not include every decision that may be of significance to partners in connection with an audit or legal proceeding. For instance, responses to audit information requests or statements of legal positions can have a significant impact on the outcome of an audit. However, the downside to allowing greater partner involvement in an audit than is necessary is that it may be difficult for the partners to present a united front on audit issues. vii If the partnership will be paying the imputed tax amount during the year in which the audit is concluded (the Adjustment Year ), the vote should be of the partners at that time. viii If the Partnership Representative is not a manager or general partner, a procedure will have to be set out for the authorization and payment of audit costs. ix These procedures typically provide that if a capital call is approved by the partners, the partners will make cash contributions corresponding to their percentage interests, and contributing partners will have an enforceable, interest-bearing claim against any defaulting partners. As drafted, this provision imposes the costs on the Reviewed Year Partners; if there will be no push out election or filing amended returns, the costs should be imposed on the Adjustment Year Partners. x Note that a partnership representative need not be a partner, but if they are not, they should sign the agreement in that capacity. Some have suggested that an accountant or attorney might be well suited to the partnership representative role; however, attorneys should consider that a limitation of liability clause such as the one here may be a violation of ethical canons unless the partners have engaged independent legal counsel to review the provision. See Rule 1.8(h)(1) of the Vermont Rules of Professional Conduct. Attorneys and accountants should confirm that their malpractice insurance policies will cover their service in this role. xi These provisions have been structured to default to a regime that imposes tax audit liabilities (and refunds) on the persons or entities who were partners during the years to which the adjustments relate, including any adjustments

18 18 P a g e to tax attributes that affect years other than the years being audited. These partners are consequently the ones who should be given the right to notice and to vote on major decisions relating to an audit (if sole discretion is not being given to the Partnership Representative). This structure is accomplished by means of a mandatory push out election; without this election (with one important exception), the partnership is liable for any tax deficiency, calculated at the highest individual marginal tax rates, and imposed during the year in which the audit is concluded (the Adjustment Year ). The exception is that the partnership s obligation will be reduced to the extent that partners file amended returns and pay their share of the tax deficiency for the Reviewed Year. A push out election comes at a cost. First, the interest rate on the tax deficiency is 2 percentage points higher than normal. Second, partners are potentially subject to the % tax rate on investment income, whereas the partnership is not. The additional interest (but not the 3.8% tax) can be avoided if the partners file amended returns, but since the partners are not required by law to amend, inequities among partners could result if some partners fail to amend and pay their share of the tax (the partnership has to pay the difference). An alternative approach is to punt on the question of who pays by leaving the decision in the hands of the Partnership Representative, but this places a lot of pressure on the Representative, particularly since there may be conflicts of interest among the partners. (see comment to 6) b. ii. below). Some practitioners have drafted provisions requiring the Reviewed Year Partners to indemnify the Partnership for the tax cost if the Partnership Representative elects to have the partnership pay the tax, but there are practical questions regarding a representative s willingness to take legal action to enforce such provisions. If this option is chosen, it would be better for the Representative to require the Reviewed Year Partners to pay up before the deadline for making the push out election, so that option is available if the necessary cooperation is not forthcoming. xii It is important to recognize that there is an inherent potential conflict of interest between the Reviewed Year Partners and the Partners in tax years who may be affected by adjustments to tax attributes. Many audit adjustments affect the timing of when income must be recognized, or when deductions can be taken; if the partners in the Reviewed Year are different than the partners in other years that are subject to potential changes in tax attributes, an audit could result in inequitable shifts in the tax burden among the partners. Since these provisions give ultimate decision-making authority to the Reviewed Year Partners (who are the ones with skin in the game when the agreement is being signed) anyone selling or acquiring an interest in the partnership should obtain their own legal counsel before selling/purchasing an interest and signing on to these provisions, as the parties may wish to take audit risks into account in setting the purchase price or agreeing to indemnification provisions. xiii These alternative payment provisions require a unanimous vote of the partners because, in the case of the amended return procedure, all partners will have to agree to file amended returns, and because, under the imputed underpayment procedure, the partnership will pay tax based upon the highest marginal tax rate, which may be significantly greater than what the aggregate tax liability of the partners would be if the adjustment were made at the partner level. In addition, if there has been a change in ownership interests between the year(s) under audit and the current audit year, the current year partners will bear the tax burden, not the partners for the years that are under audit. xiv Under the amended return procedure, in contrast to the push out election, the partners will not be subject to the additional 2% interest surcharge on their share of the tax deficiency. xv Note that, as discussed above, there is an inherent conflict of interest between current Partners and Reviewed Year Partners, if they are different. This agreement is structured to give ultimate control over audit decisions to the Reviewed Year Partners, but requires approval of the current year partners xvi In contrast with the push out election, a failure by a partner to amend returns and pay their share of tax will result in the tax burden falling upon the partnership, and therefore disproportionately on the amended return-compliant partners. To avoid this scenario, it may be advisable to include operating agreement provisions requiring members to contribute their respective shares of the imputed tax liability to the LLC before the deadline for making the push out

19 19 P a g e election, then distributing the funds back out to the members when the amended returns are filed. Alternatively, the agreement could be drafted to allow the audit tax deficiency, plus interest, to be charged against future distributions to defaulting partners, including liquidating distributions. Depending upon the situation, of course, the nondefaulting partners may not find this remedy to be satisfactory. xvii Payment by the partnership of the tax deficiency resulting from an audit, whether by agreement of the partners or in the event a partner fails to file an amended return, can result in unwarranted shifts in the tax burden among partners in cases where the reviewed year partners are different than the adjustment year partners, since the latter would bear the tax burden although the former got the tax benefit of the erroneous position. Purchasers of partnership interests will be well advised to examine the relevant partnership agreement provisions before signing. xviii Another consideration, at least until there is a technical correction, is that the % tax is not part of the imputed underpayment amount, whereas under the push out and amended return options, the partners will be subject to any applicable 1411 tax. xix Reviewed and Affected Year partners are not given a vote in this instance, since they would not bear the economic consequences of an audit adjustment if the partnership pays. xx This will be a defined term in the partnership agreement, and should be carefully analyzed, particularly if partners have varying interests in capital and profits/losses. xxi The Partners should agree to a specific procedure for payment of audit costs after termination of the Partnership. The Partnership Representative is the most logical person to coordinate collection and payment of costs, but someone else could be given that responsibility.

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